Stockholm (NordSIP) – On Wednesday, November 20th, a group of Swedish investors gathered at Nobis Hotel to hear from Paul Jackson, Global Head of Asset Allocation Research at Invesco, about his outlook for 2024. The economist provided the audience with a thorough review of macroeconomic trends, not least of which his view that we are through the worst part of the latest bout of inflation and that he expects that policy rates have also peaked and will start falling at some point in the second quarter of next year.
Beyond the analysis, his main takeaways for 2024, which can potentially have direct implications for sustainable investors, were that investment-grade debt and bank loans will do well in 2024 but that, until the economic cycle starts returning to growth, commodities will do less well. Following the presentation, NordSIP sat down with Jackson to explore these views and their implications.
The Dynamics of Energy Markets
“During 2022, the Russo-Ukrainian conflict was very good for gold as well as for industrial commodities, such as oil and gas, because the supply in those markets became constrained, due to the limits imposed on the imports of Russian oil and gas. There’s a natural process of arbitrage and substitution across energy commodities, which means that when one of them goes up, it has the tendency to drag the rest of the energy market up with it. The rise has been mitigated, but not completely reversed. This is a normal reaction. As supply fell, prices went up and the economy slowed down. Naturally, in time, demand adjusted,” Jackson tells NordSIP.
“When the economy slows down, energy and metals tend to not do so well. The negative oil prices we witnessed during the start of the COVID-19 crisis are a good example of the dominance of real economic factors in industrial commodity markets and what happens during the start of a recession. As demand collapses, there is no way to release the excess supply, inventories grow, and prices collapse. As the cycle inevitably passes the inflexion point and returns to growth, demand will return,” Jackson adds.
Internalising the Cost of Pollution
“One of the main issues is that the cost of pollution is not correctly internalised,” Jackson argues. “The 2006 Stern Review suggested that the social cost of carbon on a business as usual trajectory of $85(€75)/ton of CO2. At that time, the price of carbon in the EU emissions trading system (ETS) was below €30/ton of CO2. Worst still, the price fell and stayed below €20 between for ten years after 2008. The price only reached the Stern calculated social cost level in November 2021, and has since even increased above €100/ton of CO2. Unfortunately, the world lags behind Europe. In California, the price of carbon remains as low as US$29/ton of CO2,” Jackson says.
Set up in 2005, the ETS takes a cap on emissions and creates a market for emission allowances that can be auctioned by the EU to companies and that can then be traded in a secondary market. The history of the EU ETS is, so far, divided in four phases. The first two periods, covering the years of 2005-2007 and 2008 to 2012, was seen as a period of learning, market by excess allowances and by a lack of coordinated national markets. Understanding this issue, the third phase, from 2013 to 2020, the cap on emissions has been set for the EU as a whole and started to be decreased (for stationary installations) “each year by a linear reduction factor of 1.74%”. In phase 4 of the EU ETS (2021-2030), the cap on emissions continues to decrease annually at an increased annual linear reduction factor of 2.2%. These adjustments can help understand the rise in in CO2 prices in the EU and the increased correlation between the movements in industrial energy prices and CO2 prices.
Energy Investors and ESG Fund Managers
In the past, NordSIP has noted that there have been some periods of booming flows into ESG funds. Despite the rise in commodity prices highlighted above, investor interest for ESG investing was clear in 2020, in 2022 and seemingly, Refinitiv’s most recent analysis of UK bond fund flows suggests that sustainable funds have not lost their appeal.
Jackson argues that there are limits to the flows between energy assets and interest in sustainable funds. “The people buying renewable energy funds are not the same as those who buy funds that invest in oil and gas companies. The first tend to have a tighter mandate that restricts them away from industrial commodities,” Jackson argues.
“The market for commodity trading, rather than for actual operational industrial needs, is relatively small from the point of view of investors for whom those investments tend to represent a small part of their portfolio. Commodities have a lot of volatility for the level of returns that they provide. However, they are also not very correlated with the rest of the market so portfolio optimization suggests a strategic position in commodities. This is the view that some investors take,” Jackson continues.
“On the other hand, I fear that opportunities to invest in clean energy are still relatively small when judged by market capitalisation. We need more companies to be created and more money to flow into these markets to mitigate the liquidity problems created by this lack of capitalisation,” Jackson explains. “At the same time, it’s important to understand that large companies publicly listed on exchanges that do clean energy are probably not exclusively dedicated to clean energy. Safe for some exceptions, they are probably larger energy companies that have recently started diversifying into renewable energy. The best and purest clean energy opportunities are probably found in early-stage financing of small, innovative businesses. This is an environment that is particularly favourable for venture capital/private equity and not something that is necessarily accessible to large equity funds,” he warns.
The way forward
According to Jackson’s longer-term outlook for the rest of the century, he believes the best-performing assets will continue to be equity and real estate. “Climate change and the way in which it spills over to the performance of all asset classes will be very important. In my opinion, companies that position themselves to benefit from carbon mitigation by enabling us to reduce CO2 emissions or by investing in carbon capture (be it through reforestation or through new technologies) will perform well,” he says.
“The other climate opportunity is in climate adaptation. It is possible that we might be moving towards a 3⁰C world rather than the more environmentally desirable 1.5⁰C targets global leaders set themselves. If that’s the scenario that ends up materialising, businesses, investors and countries that have prepared for this reality are likely to outperform their competitors,” Jackson concludes.